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...individual company not well understood. This study focuses on explaining variations in response to leveraged buyback. The study suggested that shareholders like a LBB when the size of the LBB is small and the principle behind it is to supplement their dividend income. However, in cases when the company announces a substantial LBB the shareholders perceive it as bad news. This is because the shareholders feel that such a major restructuring of the capital structure at the hands of an untrustworthy management would put at risk not only their dividend income, but also their original investment.
Introduction
The relationship between capital structure and value was one of the first problems in finance to be addressed using scientific methods. However, there is still much that is not known about how capital structure affects value. Numerous studies have focused on the value impact of changes in capital structure, including repurchase of common stock. Previous research (Loomis, 1985; Wansley and Fayez, 1986; Davidson and Garrison, 1989) has found that positive abnormal gains accrue to shareholders of firms, which enter into share repurchase deals. Their research does not, however, allow us to identify reasons for this abnormal increase.
This research is aimed at studying the impact of a Leveraged Buyback (LBB) announcement on the market price of the stock of a company. The research will further try to isolate variables, which may be responsible for this increase and can be used in the future to predict the market price performance of the stock of a company after all LBB announcement.
Previous research has identified several possible reasons for a share buyback, among the reasons cited include: to correct price-value divergences, to distribute excess capital, to line tune the capital structure, to send signals to the market, to provide a tax benefit to shareholders, to avoid takeovers, to counter dilution effects of stock options, to provide for agency problem solution etc.
This research initiative has two main objectives. The first focuses on determining whether abnormal positive returns accrue as a result of an LBB announcement. The second part of the research will focus on identifying some of the possible variables which theory dictates may be responsible for this increase.
Theory suggests several possible reasons for these positive abnormal returns, these include: reduction of free cash flow or debt capacity, signaling of management's optimism, distribution of tax preferred income, and dividend clientele effect. Variables representing these reasons will be used as independent variables and regressed against the excess returns occurring at the announcement time.
The variables used to test for each possible explanation are as follows:
1. Reduction of Free Cash Flow or Debt Capacity:
Free Cash Flow
Debt Ratio
Return on Assets
Market to Book Value
Earnings to Price Ratio
2. Signaling of Managements Optimism:
Percentage of Management Ownership
3. Distribution as Tax Preferred Income:
Holding Period Return
4. Dividend Clientele Effect:
Retention Ratio
Dividend Yield to Total Returns Ratio
This research effort will provide new evidence for students of capital structure by identifying some of the important variables that are responsible for the excess returns. Corporate managers will benefit from this research through identification of variables, which are perceived to be important to the shareholders. This information will benefit them in their strategies to maximize the wealth of the shareholders. The results of the research will also benefit regulators in their understanding of the pertinent variables that affect the value of the company in such transactions, thereby enabling them to better look after the interests of the shareholders.
Literature Review
Austin (1969) and Masulis (1976) through extensive surveys found that the most important purpose of repurchasing stock was the executive compensation plan. They also found that 57% of the shares repurchased between 1961 and 1967 were reissued to corporate insiders. Another reason cited by Vermaelen (1984) was to resist attempts by outsiders to take control of the firm. Insiders-managers especially want to signal to the market the true value if the stock is undervalued, and therefore a choice takeover target.
Wansley, Lane and Sarker (1989) conducted a survey of chief financial officers of large U.S. corporations to determine the managerial reasoning and attitude towards share repurchase. The survey found that managers did use share repurchase to signal to the market their confidence in the firm, thus supporting the information-signaling hypothesis of share repurchase. The survey results did not support the idea that share repurchase was conducted to boost the market price of stock that was low or because management's proportional ownership was down. Sinha (1991) presented a model in which managers of takeover targets use share repurchase to bond themselves to reduce perquisite consumption and increase investment in the firm.
The seminal papers on capital structure were written by Modigliani and Miller (1958, 1963) in which they showed that in the absence of taxes the value of a company was independent of its capital structure.
However in a world where the government subsidizes interest payments on debt capital by allowing companies to deduct interest payments as an expense, the company can increase its market value by taking on more debt. Given the assumptions of the model, M&M showed that the value of the firm would be maximized when it takes on 100% debt.
Several additional empirical studies focus on the price impact of a share repurchase. However, the authors of these studies do not claim that the results support one theory or the other. These studies are summarized in the following paragraphs.
Loomis (1985) conducted a survey in which he analyzed the shareholder returns of companies that had voluntarily repurchased substantial portions of their common stock between the years 1974 and 1983. Loomis compared their returns with the S&P 500 stock index and showed that the stock of the buyback companies showed an annual average return of 22.6% as compared to a return of only 14% on the S&P 500 stock index. He stated that the buybacks performed well for the shareholders only in cases where the stock was initially undervalued.
Wansley and Fayez (1986) studied the impact of share repurchase announcements on the returns of security holders of Teledyne Corporation. They found that positive abnormal returns accrued to common shareholders. They also found that subsequent share repurchase announcements did not diminish the absolute level or the significance level. They concluded that a wealth transfer takes place from bondholders to the shareholders that nullifies previous contradictory, evidence in this case.
Davidson and Garrison (1989) also studied the impact of share repurchases on the repurchasing...
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